Chinese monetary policy is driven primarily by RMB speculation

There is an article in this week’s Caijing that summarizes a survey by Deutsche Bank’s Jun Ma (here, for those who can read Chinese). I haven’t managed to get it translated yet but one of my regular blog readers, Kar Kheng Giam, summarized it for me.

According to the survey, the ways enterprises bring into China what, from a monetary management point of view, is either hot money or its functional equivalent, is broken down according to the following. 52% of the money comes in the form of FDI, which I assume means an acceleration of approved FDI flows. 21% of the money, roughly evenly split, comes from under-invoicing imports or over-invoicing exports. 8% consists of “foreign donations” – I am not sure what this means. 5% comes from exchanging money with underground money exchangers and 17% comes from various other means, including paying local employees or service providers in foreign currencies, borrowing in foreign currencies, and so on

Among individuals and households, which I assume include some of those local employees mentioned above who are sometimes paid in foreign currency, nearly half of the foreign currency funding for their purchases of RMB (49%) reportedly comes into China via the US$50,000 per year transfer from abroad permitted to residents, while another 20% enters via the RMB10,000 per day limit from HK banks. 15% of speculative inflows enters China via exchanges with local relatives or friends, 9% via underground money exchangers, and 7% via what I assume are legal money changers.

The survey seems to confirm what we had more or less guessed – there are an awful lot of ways to bring money into China and what is driving the speculative inflows are some pretty ambitious expectations of RMB appreciation. The very large trade and investment accounts are a particular important channel for hot money and the family businesses with networks both inside and outside the mainland are likely to be particularly efficient at bringing money in (and are likely to be no less so at taking money out again one day).

The survey also suggests that the “unexplained” portion of reserve accumulation – after backing out the trade surplus, FDI, interest income and revaluation gains – is biased downwards, since there may be substantial amount of hot money in the trade and FDI numbers. Take this out and add it to the “unexplained” part and the most stable sources of reserve growth – FDI, the trade surplus, and so on – are becoming an increasingly small fraction of total net inflows. Chinese monetary policy, in other words, is at this point almost entirely driven by hot money inflows.

This is a pretty disturbing conclusion and bears repeating: Chinese monetary policy is largely a function of massive and very volatile speculative inflows driven by RMB appreciation.

Headline reserve growth for the first four months of this year was a breathtaking $228 billion. We know that this number understates real inflows because of the redenomination of minimum reserve requirements and the transfer of assets to the CIC, and my best estimate is that adjusting for these reserves would have climbed by $340-370 billion. Of this approximately $45-50 billion consists of interest income and valuation gains. The trade surplus and FDI accounts for $94 billion, but almost certainly a large fraction of this consists of disguised hot money.

Even ignoring the disguised hot money, that still leaves $200-230 billion unexplained. Part of this unexplained amount will include such things as net tourism and some non-speculative financial transactions, but these aren’t likely to be large numbers, and I suspect that all of them together are probably less than the hot money inflows disguised in the trade and FDI accounts, or at least not a whole lot bigger. A plausible guess, then, is that hot money inflows are greater than the headline reserve growth, or at least not a whole lot less.

Since the PBoC must monetize these inflows – either by issuing currency or by issuing central bank bills – these inflows end up adding to the country’s money base. With the largest part of the inflows probably consisting of speculative money, that is what I mean by saying that Chinese monetary policy is now driven primarily by RMB speculation.

The article in Caijing includes recommendations about what should be done to reduce hot money channels – for example improving the monitoring of FDI-financed companies’ holdings of cash, stock and bond holdings, building databases to track import and export pricing, reducing the amounts convertible per annum or per diem, and stepping up scrutiny of underground money exchangers – but I suspect that given the variety of channels, the difficulties of monitoring, and the problems with fraud and corruption, there is not a whole lot the authorities can do to deter inflows, except perhaps drive it further underground.

For example, if the $50,000 that residents are permitted to bring into China every year were reduced, I suspect we would simply see a surge in the trading activity of the underground money exchangers. At any rate just the size of the trade and FDI accounts means that a little fudging of the numbers there can lead to some fairly deep channels for inflow. What’s more, stepping up the monitoring of trade-related and FDI-related activity comes with the inevitable corollaries – reducing real economic activity by increasing bureaucracy and frictional costs, and increasing the scope for and profitability of corruption, neither of which is good for China’s short-term or long-term growth prospects.

The survey also asked these “speculators” how much appreciation they expected for the RMB. I am not sure how representative the survey is, and anyway I don’t think these target levels need to be taken very seriously because there is a lot of empirical evidence that suggests that our price targets are heavily affected by current price levels, and tend to change (usually in the same direction) as prices change. Still, for what its worth, here are the target ranges.

Expected RMB per dollar Percent of respondents
6.0-6.5 17%
5.5-6.0 57%
5.0-5.5 26%
4.5-5.0 14%
4.0-4.5 6%

The total, mysteriously enough, adds up to 120%, but it is interesting that those sampled by Jun Ma seem to have fairly aggressive appreciation expectations, with more than one-third of them expecting the RMB to go through 5.5 to the dollar – for a total appreciation of over 25%. The author of the article argues from this however that as the RMB approaches 6.0 China will begin to experience hot money outflows that could quickly turn into a flood, especially if the market then experiences a financial or economic crisis. 6.00 RMB per dollar represents a little more than a 15% appreciation from its current level of 6.93.

I am not sure I agree that beyond that level we will see a great deal of outflow. As the RMB steadily appreciates towards that number I suspect that arguments are going to be widely made about a higher equilibrium level, and the market will move towards higher appreciation expectations. That is what usually happens in similar cases – rising currencies seem, at least for a while, to create expectations of continued rising, and certainly the experience of Japan in the 1980s, Germany in the 1970s, and other surplus countries is that, once it starts, appreciation can go on for a very long time. .

At any rate, given China’s huge reserves, there is no reason for speculative investors to race to the exits once their target level, whatever that is, is met, unless they expect significant depreciation pressure to follow, which I think is unlikely and can anyway be addressed by a credible peg (and nearly $2 trillion in reserves). Their decision as to whether or not to keep their money in China will hinge on other factors – mainly the opportunity cost of holding money abroad relative to the expected returns of holding money in China. Where I do agree with the author is that if the RMB’s trading in the 5.50 to 6.00 range coincides with a financial market collapse or a sharp economic downturn (which is likely to be the same thing), we might see sudden massive capital outflows. But the key thing here is the condition of the market, not the level of the RMB.

One of his conclusions, then, is that China cannot afford a one-off revaluation of 15% or more because that brings the RMB into the capital flight danger zone. I would not conclude the same thing. His data only (perhaps) suggests that China should not attempt a one-off revaluation in the midst of a financial or economic crisis, which I think is probably an obvious enough conclusion. If anything I would argue that China needs to move quickly on the currency front precisely so as to obviate the need for a maxi-revaluation when the risk of a crisis is higher. Every month that China has to deal with the massive inflows it is experiencing means a riskier financial system.

5 Responses to "Chinese monetary policy is driven primarily by RMB speculation"

  1. Victor   June 4, 2008 at 8:39 pm

    I also agree that there is little risk of capital flight. However, part of the government’s strategy now seems to be tightening domestic money supply so that neither stock or real estate does well. Then, even with the expected revaluation, the investors’ return is no longer spectacular as was the case a year ago. I think bad macroeconomic environment means that they will "succeed" either way. That is, if monetary policy does not tighten, China will see high inflation, which will hurt the stock market (since price control will generate losses among large, listed SOEs–more on that in my upcoming blog post). If tight monetary policy is implemented, the real estate market will have a hard landing. Either way, inflation pressure means there is no longer high confidence in making high return by getting into China.

  2. Guest   June 4, 2008 at 11:19 pm

    It’s much harder to leave a pegged FX regime than to enter one. What a rut China got itself into! How can it exit gracefully…

  3. CHEN jiyao   June 5, 2008 at 1:40 am

    Prof Pettis and Prof VictorI also read today’s news saying that Vietnam is now experiencing high inflation ratio of 25% since the May of this year. Now massive capital flight is taking place, causing a drastic decline in the value of VND agaist the U.S dollar and RMB. People are lining up to convert VND into RMB or US dollar and usually they need to wait 15 days at least to do so. Although in China such massive capital outflow is far less likely due to CHina’s strong restrictions, does Vietnam’s experience in some way forshadow a bit of China’s future fate?

  4. Michael Pettis   June 5, 2008 at 4:39 am

    Chen, I have been following Vietnam to some extent and I think the conditions there are very different. For one, Vietnam was running a fairly large trade deficit, and it was massive invesvestment inflows that forced monetary expansion for so long. Any reversal of these inflows would be much more severe for Vietnam than for China, whose trade surplus reduces the exit pressure. Vietnam also experienced a stock market bubble much greater than what China has so far expreienced. In that sense Vietnam looks a lot more like the pre-1997 Asian-crisis countries than like China.

  5. Yeoh Seng-Hooi   April 30, 2009 at 1:19 am

    Message for Giam Kar Kheng – Please reply to me if you are my friend from Penang. Yeoh Seng-Hoo